How to read financial statements of a company?

Financial statements are the soul of any business. The financial statements are intended to give a true and fair picture of the company in terms of profitability, capital adequacy, asset quality, solvency and liquidity. If you own shares in a company, you must be getting the annual reports (nowadays it is by email). These annual reports contain the three principal financial statements of any company viz. Income Statement, Balance Sheet and Cash Flow Statement. Let us look at how to read financial statements with specific reference to these three pieces of financial statements.

How to read interpret the Income Statement?
The income statement or the P&L account gives some useful insights into the functioning of the company. Here is what you need to look at in the Income statement.

  • Are the sales growing consistently over time and what is driving the growth in sales; volume growth or pricing power.
  • What is the contribution margin generated post the variable costs and how effectively does it cover the fixed costs.
  • How well does the Earnings Before Interest and Taxes (EBIT) cover the interest cost and what does that say about the solvency of the company.
  • How do the operating profit margins and the pre-tax margins of the company size up over time and how does it compare with the peer group.
  • What is the ratio of the sales to the fixed assets in the balance sheet and what does it say about the efficiency of the company’s operations.
  • What is the fully diluted EPS of the company and how does the P/E ratio compare with the peer group.
  • How is the company’s dividend payout policy and has the company been able to maintain a steady dividend payout ratio?
Answering the above questions will give you a good idea of the profitability, sustainability of margins and shareholder rewards implicit in the stock.

What to read in the Balance Sheet?
When you talk about how to read financial statements, the balance sheet is pivotal as it is a statement of assets and liabilities of the company. Here is what to read in the balance sheet.
  • The debt equity ratio is the key to balance sheet leverage. Here you consider the ratio of long term debt to total equity, including the share capital and the free reserves.
  • Focus on the ratio of short term debt to long term debt. Here short term debt should include the current liabilities and long term debt maturing within one year. A high proportion would mean pressure on liquidity.
  • Is there a negative working capital cycle? That is evident from an analysis of current assets and current liabilities. It indicates how liquid the current assets are, how quickly can the company churn sales and whether the current assets can meet the current liabilities when they arise.
  • Look at the ratio of market capitalization to total assets as it gives you an idea of how much of the stock value is attributable to intangible factors like brands, networks, franchises, governance standards, etc.
How to read and interpret the Cash Flow Statement?
India follows accrual system of accounting so income statements cover items accrued and not incurred. That is covered in the cash flow statement. Here are two things to look for in the cash flow statement.
  • Look at “Cash flow from Operations”. A healthy sign is if the cash flow from operations is positive and large enough to compensate for the cash outflow from investing activities. For any growing company, the cash flows from investing is negative and the more it is funded from operations, the better it is.
  • The cash from investments is compared with the cash flow from financing as it gives a quick idea of how much of the capital expenditure is financed and at what cost. The cost of financing must be lower than the IRR of the business to ensure healthy spreads.
Additional statements to evaluate
Some of these are not strictly financial statements but they are adjuncts to the financial statements.
  • Go through the management discussion and analysis (MDA) as it gives the best picture of the future  vision of the top management.
  • Check if there are any qualifications in the audit report, especially serious ones pertaining to non-disclosure, group transactions, etc.
  • Go through the notes to accounts, especially the part referring to the contingent liabilities and other hidden risks
  • Finally, go through the investment portfolio details and see if there are any value red-flags you can identify
Once you go through this elaborate process, you are all set to take a view on the stock.

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